Taking stock of the current investment climate

The Irish stock market has been particularly badly ravaged by the credit crunch and many investors are now paralysed by fear when trying to decide where to put their money. So what are the best options available to them, asks CAROLINE MADDEN

THE DESTRUCTION of global stock market values over the past two years has left investors running scared. The Irish market, with its heavy concentration on financial stocks, has been particularly badly ravaged. Since peaking at more than 10,000 in February 2007, the Iseq index of Irish shares has fallen spectacularly from grace and now languishes below the 3,000 mark.

The anger of Irish investors is palpable at corporate annual general meetings, where previously well-heeled individuals now share hard-luck stories and vent their anger about their supposedly blue-chip investments.

Even individuals who did not risk their money through direct stock market plays have been exposed to the collapse in share prices through their pension funds. The average pension fund shrank in value by more than one-third last year.

There are signs – albeit tentative ones – that pension funds are staging a small recovery. For the first time since last August, Irish pension funds delivered a positive performance during March and last month they jumped by an average of 8.7 per cent – the highest one-month gain in several years. However, pension experts warn that it is too early to know whether this signals the bottom of the market, and individuals approaching retirement do not have the luxury of time to wait for a full-blown recovery.

Given the current volatility, it is a difficult time for investors to decide where to put their money. It’s all well and good for renowned investor Warren Buffett to advise people to be brave when others are fearful, but even the previously infallible Sage of Omaha lost more than €200 million on an investment in Irish banking stocks.

It is not just investors who are paralysed by fear. Investment professionals are struggling to find products that will gain traction in the market. With dire recent performance statistics, there is little demand for the equity-led products that dominated investment house portfolios in recent years. So what are the areas in which they are currently concentrating and what investment strategies should individuals follow to preserve, and hopefully grow, their wealth?

In times of uncertainty, funds that guarantee the return of the investor’s capital tend to soar in popularity, and this bear market is no exception. But do capital guaranteed funds offer value for money?

For investors brave enough to return directly to the stock market, what strategy should they pursue? One school of thought suggests that investors must diversify away to other markets to avoid having an overexposure to the Irish market. However, others warn against a knee-jerk reaction against the Iseq and argue in favour of a sectoral, rather than a geographical, approach to constructing a balanced portfolio of stocks.

CAPITAL GUARANTEED FUNDS – GOOD VALUE?

Given the unprecedented levels of volatility and wealth destruction in investment markets since the credit crunch struck, it is understandable that investors are craving guarantees that their money will be safe.

This explains the growing popularity of capital guaranteed investment funds. Guaranteed products proliferate in times of stock market uncertainty and, according to one investment expert, are “the only game in town” at the moment.

The idea is that you hand over a lump sum to the provider (often an insurance company), which guarantees to return most, or all, of that lump sum at the end of a specified term, for example five years. Clearly, such a guarantee offers peace of mind.

In addition, such investments offer you the chance to share in some of the upside of the performance in the underlying assets.

However, mention guaranteed funds to financial experts and they will point out that there are several catches (unless of course they’re trying to sell one of these products to you).

Gary Connolly, head of investment with broker network Citadel, recently carried out a review of the capital guaranteed offerings available on the Irish market, and identified three main problems with them.

“The primary one is that, generally, when you’re investing in a guaranteed fund, you’re only earning a return from the price appreciation [of] whatever index it’s tracking,” Connolly says.

“In 95 per cent of capital guaranteed funds, the return you’re getting excludes the dividend that the companies in those indices are paying.”

This is quite usual for such products. Capital guaranteed funds often track the performances of indices, but in capital terms only, ie, the investor is not entitled to any dividend income from the underlying stocks in each of the indices. “The vast majority of mainstream indices are quoted in price terms only,” Connolly says.

He estimates that if you were to invest in a guaranteed fund with a five-year investment term that tracked, for example, the FTSE 100, the Eurostoxx 50 and the SP 500, you could lose out on about 3.5 per cent a year because these indices are “price only” – ie, the dividends earned on the underlying companies are not included. Compounded over five years, the rate of dividend income works out at roughly 20 per cent, a significant price to pay for a capital guarantee.

The second issue Connolly has with such products is that they “cap the upside”. For instance, an investor might be limited to receiving just 60 per cent of the upside in a fund’s performance, as a percentage of their money will have to be tied up in cash to underwrite the guarantee to return the initial investment should markets move the wrong way.

The third problem with guaranteed funds, according to Connolly, is “the averaging at the end of the period”. In other words, providers of capital guaranteed funds sometimes offer to average the performance of the index/indices that it is tracking over the last 12 months of the investment term.

“This is marketed as saving you from a big fall in the index towards the end of the term, but really what it does is it cheapens the option [a product bought by the fund manager to track indices] for the provider,” he says. “I don’t like averaging because it’s marketed as being good for the client, whereas in fact it’s not.”

John Lowe, managing director of Providence Finance Services, says that, while the capital you invest may be guaranteed, there is no guarantee of growth on that capital.

Lowe sums up this investment proposition by comparing it to the parable of the talents, in which a servant buried a silver talent in the ground for safekeeping and later returned the original amount to his master, who cast the unprofitable servant “into outer darkness” for not placing the money in the bank to generate interest.

“There’s no point giving somebody money for five years and then just getting back the money in five years’ time,” he says.

In a more normal environment, Lowe’s advice is spot on. However, these are not normal times, and Irish investors – and the industry at large – are badly rattled. The appetite for risk of any sort among investors here is perhaps best illustrated by the 95 per cent rise in the sales of prize bonds last year; just 1 per cent of bond holdings were encashed.

Prize bonds can, and do, produce a yield in the shape of monthly prizes. However, one of their selling points is that, even if you never win a prize, you can always redeem your original investment, ie your capital is guaranteed.

In normal circumstances, your money will be worth less as inflation undermines its value; however, even that is not the case at the moment. The deflation being experienced in the economy means your money is likely to be worth more if you redeem it down the line.

Similarly, in a distinctly underwhelming year for An Post, the one illuminating feature was the increase in the sale of guaranteed products backed by the National Treasury Management Agency (NTMA) such as savings certificates and savings bonds.

This reflects the experience of many in the Irish investment market, who say most product-design effort at the moment is concentrated in capital guaranteed products because – rightly or wrongly – that is the area where there is a demand.

However, Lowe is adamant: “At this volatile time, I have to say I wouldn’t be actually recommending that people go into some of these products. The whole idea is about preserving and retaining your money. If you can’t understand it and it’s too good to be true, I would recommend you walk away.”

Lowe sounds another warning that, a year ago, would have seemed outlandish. The insurance companies providing the capital guarantees may seem like solid companies, but then US group AIG, which came close to bankruptcy last September, also seemed solid, he says. So investors should take into consideration the strength of the company offering the guarantee.

“The underlying guarantee is [from] the entity itself – there’s no guarantee that [it] is going to be solvent ad infinitum,” he says.

Capital guaranteed products may all seem similar at first glance, but the underlying strategies and terms vary significantly, so it can be worth seeking advice before making an investment decision. For example, some funds invest in a basket of stocks picked by the provider’s investment team, whereas others are passively managed and simply track indices. In addition, the capping mechanisms vary, depending on the fund.

It is also important to be aware that a large portion of the lump sum you invest in a capital guaranteed fund will probably end up sitting on deposit.

From the provider’s point of view, this is necessary to provide the guarantee to return your original investment – or the agreed portion of it – in the event of the market falling during the term of your investment.

At the moment, if an individual invested €100,000, as much as €82,000 of that could go straight on deposit, Connolly says.

“Because interest rates are so low, more and more money is having to go on deposit to provide your guarantee,” says Connolly. “So the reason that the value in these products isn’t great at the moment is that interest rates are low, and volatility is high.”

Investors must ask themselves whether it makes sense to pay management charges and fees to get a fund manager to place a large chunk of their money on deposit.

There is an argument to be made that if an individual had a lump sum of, say, €100,000, they might be better off putting €82,000 on deposit and investing the balance elsewhere themselves.

DIVERSIFY AWAY FROM THE IRISH MARKET?

A second trend in the current turmoil has been the increasingly popular tendency to write off the Irish stock market as a washout and extol the virtues of looking further afield when building up a stock portfolio.

While it is true that many individual investors and pension fund managers have been burned as a result of their overexposure to the domestic market, which in turn was overconcentrated in financial stocks, experts caution investors against throwing the baby out with the bathwater.

Joe O’Dwyer of Merrion Capital Investments advises investors hoping to reduce their exposure to the woes of the Irish economy against a knee-jerk reaction.

“The amount of earnings of the Irish stock market that’s related to the Irish economy now is relatively low, so buying or selling on the Irish stock market is not taking a view in terms of the Irish economy.

“What you should be doing is buying quality companies that are good within their sector,” he says. “I would be concerned that people are being advised to sell Irish equities as a geographic economic theme when it is intellectually lazy. When you look through it, there are a lot of very good companies [on the Irish market].

“Currently the companies that constitute the biggest weightings on the Irish market are CRH, Ryanair, Kerry Group, DCC, Dragon Oil, Glanbia – all good-quality companies, all of whom have outperformed their respective sectors globally over the last eight or nine years. So when you’re looking at an equity portfolio, you shouldn’t look at things regionally. People should look at things sectorally. I wouldn’t be selling those companies.”

He adds: “The big problem with the Irish stock market for the last year has been its structural, historic, high exposure to the financial sector as distinct from the individual stocks within themselves, and that issue to some extent has now passed.”

Killian Nolan, investment manager with RaboDirect, agrees that it is unwise to dismiss the Irish market out of hand. “If you had somebody who’s buying individual shares, it would be silly to just discard them because they have an Irish tag,” he says.

“But on the whole I think definitely people need to look further afield . . . There’s certainly an argument for having some Irish equity, but in the context of the overall allocation it should be small.”

He says the Irish market is an “absolutely tiny” part of the global stock market. “So if you’re an investor, having 20 per cent of your [portfolio exposed] to the Irish market could be seen as being foolish.”

James Forbes of Irish Life Investment Managers believes the key is a balanced approach. “There are some quality Irish stocks out there that compare well with the best in the rest of Europe and the rest of the world,” he says.

“There’s no point throwing the baby out with the bathwater. But at the same time, if you’re a private investor, there’s no point in having 40 per cent of your portfolio in CRH. It doesn’t make sense.

“From a risk perspective, it does make a lot of sense to diversify broadly through the various sectors and the various geographies.”

While the Iseq still boasts many good-quality companies whose earnings are largely generated outside of Ireland, the banking sector remains out of favour.

Not surprisingly, the consensus is that the fate of the banks is too uncertain for them to be attractive investments. The full details of the National Asset Management Agency (Nama) have not yet to come to light, and many international investors are reluctant to touch the banks because of a lingering fear that they could end up being nationalised.

SHOULD INVESTORS STOCK-PICK?

According to Merrion’s Joe O’Dwyer, the events of last winter have led to “a generational buying opportunity for equities”.

Regardless of the truth of this statement, such an approach is an option only for investors who are comfortable with risk and have a longer-term investment horizon.

It will do nothing for the nerves of battle-scarred investors but, for investors who share this bullish view, what is the best approach to getting into the market?

Citadel’s Gary Connolly warns that anyone who is not a professional investor should “tread very carefully” if buying individual stocks.

“I would caution people [against] buying stocks individually other than for small parts of their portfolio,” he says.

“People should really look down the fund route before they should consider buying individual stocks.”

However, funds “haven’t exactly covered themselves in glory” either, he notes.

If investors are deterred by the poor performance of actively managed funds or object to paying large management fees and charges to fund providers, they should consider buying exchange-traded funds (ETFs), Connolly says.

Essentially, an ETF combines the diversity of a fund with the liquidity of a share, and enables investors to gain exposure to a particular market or asset class in a single transaction.

Constructing a balanced portfolio is not as straightforward through the ETF route as it is with managed funds, which typically split assets between a mixture of cash, bonds, equities and property. But Connolly says individual investors could theoretically construct their own “managed fund” through ETFs, for example by using 70 per cent of their funds to buy an equity ETF, 20 per cent to buy a fixed-interest ETF, and so on.

Until now fund managers have succeeded in fending off competition from ETFs, but Connolly says this type of investment product is now “steaming up on the inside”, because it allows investors to access markets cheaply.

And with investors growing tired of handing over hefty commissions and charges to underperforming investment managers, anything that offers better value is worth considering.